Japan on the Knife Edge

"On any measure, Japan is the most indebted sovereign rated by Fitch," Colquhoun, Hong Kong-based director at the company's Asia-Pacific sovereign group, said in a conference call today.

...The yield on Japan's 10-year bond was unchanged at 1.315 percent

The Congressional Budget Office now forecasts that the U.S. will have a ratio of government debt to GDP of 90 percent by 2020. However, that seems low relative to Japan, which already has a ratio of close to 200 percent. How does Japan do it? Some thoughts below.

Imagine that you have an investment in a rental property financed in part by a loan. Suppose that you have an operating loss (the rent on the property is less than the expenses). How can you hold onto the property? There are three issues:

1. The size of the loan. If it were small, you could perhaps continue to borrow in order to hold onto the property, with the lender hoping that you can eventually turn the operating loss into a profit.

2. The size of the operating loss. if it is small, then your debt may not grow terribly quickly. Again, the lender may be willing to extend the loan in the hope of a turnaround.

3. The interest rate on the debt minus the rate of price appreciation of the property. Call this the erosion factor. If the erosion factor is low, then it will take a long time before the debt burden becomes unbearable. If the erosion factor is negative, then you may actually have a sustainable investment.

These are also the three factors at work in the world of sovereign debt. The amount of outstanding debt matters. The "operating loss" is what is known as the primary deficit, meaning government revenue minus spending other than interest. The erosion factor is the interest rate minus the growth rate of GDP. Now, the government does not have an ownership stake in GDP in quite the same way that a landlord has an ownership stake in a rental property, but the arithmetic of government debt is such that the analogy holds fairly well.

The erosion factor can be negative for government debt. That is, the nominal interest rate may be less than the rate of GDP growth. That is in fact what happened in the United States after World War II. Nominal interest rates were low. Ex post, investors who bought U.S. government debt from 1945 through about 1975 suffered negative inflation-adjusted returns.

Which brings us to Japan. The size of the loan is high--200 percent of GDP, the highest in the industrialized world. The size of the operating loss is also high. According to the Wall Street Journal,

Another idea is to aim to cut the ratio of Japan's overall deficit to about 6% of GDP by the year ending in 2016, then to 3% or below five years later, the officials said. The figures compare with 9.4%, or 44.8 trillion yen, expected by the cabinet office for the current fiscal year.

One thing that Japan may have going for it is a negative erosion factor. With a ten-year interest rate of 1.315 percent, if nominal GDP rises at 5 percent per year (say, 2 percent real growth plus 3 percent inflation), the erosion factor would be negative 3.685 percent, which would be sufficient to offset a primary deficit of 3 percent of GDP. The question, though, is whether investors will tolerate negative real returns from holding Japanese government debt.

Suppose that investors wake up next week somewhat nervous about Japanese government debt. Suppose that the interest rate goes up to, say, 2.5 percent. It seems to me that this might be enough to make Japan's long-term fiscal outlook untenable, in which case there is nothing to stop interest rates from climbing to, say, 10 percent, a point that rates have almost reached in Greece.

If the interest rate on Japanese debt were to hit 10 percent, then Japan would require 20 percent of GDP just to meet interest payments. Presumably, they would have no choice but to default.

The point here is that with such a high debt level and a high "operating loss," the only thing that Japan might have going for it is a low (possibly negative) erosion factor, which in turn depends entirely on the willingness of people to lend to the government at low interest rates. A loss of willingness to lend would turn into a rapid fiscal death spiral. I suppose that the arguments for "this time is different" are largely cultural. Japanese savers are willing and able to supply massive sums at low interest rates, the Japanese political system could make drastic budget cuts quickly, or some such.

the difference between Greece and Japan is: who is holding the debt?
in the case of Greece it is mostly foreign, and in the case of Japan mostly domestic (sorry no exact figures). this makes it more tenable imo.

I am very confused by the Japanese situation. I would have thought, ex post, that large government deficits, and the accompanying floating of increasing amounts of government debt, would have already led to an increased amount of liquid securities. These money-like securities would essentially be increasing the money supply and this would have already caused higher inflation. But why hasn't this happened? Maybe simultaneously private lending has decreased and monetary policy has been relatively tight, thus cancelling out the inflationary effect of increased government debt. I find it hard to believe that the reason is the Japanese savings rate. Interest rates and inflation seem to be to be determined mostly by global currency and fixed-income markets because any discrepancy can be arbed away. I've alwasys wondered how Japan has kept interest rates and inflation so low for the past 2 decades in the face of rising government deficits.

I believe only Zimbabwe has a worse GDP/Debt ratio. Since Japan has not imploded (yet?), something else is going on. Perhaps the present value of expected net imports helps. Further, debt owed to oneself is of a different nature than debt owed to others---in practical terms at least.

The reality is Japanese citizens are less rich than they individually believe. Their high personal savings is simply lent to the government and this effectively offsets private savings. "Savings" in this sense has no meaning. It really means "less income". But they still may have enough, net, to just keep on going.

This is intuitively supported by how many citizens live---very small homes and very long commutes.

Japan financed the bonds with savings. Due to their demographic profile, savings are near zero and headed into negative territory. Japan will need foreign capital to finance their debt going forward.

The question isn't who holds the debt, it is who will buy the marginal debt. Bankruptcy is an event, not a condition. If people lend to you, you are solvent. If they don't, you're broke.

Relating back to the financial singularity, I think the key point is that people do wake up one morning and change their mind. Imagine someone on the other side of the singularity, will they view you as unlucky for buying Japanese debt or a moron for ignoring the obvious?

The bond market of 2015 or 2025 will not have the same profile as the market in 1995 or 2005. The government is not driving into a brick wall, the crisis debt level is not static. They are driving into an oncoming train.

I believe if you looked at it you would see the coupling of many effects.

1. Japan had a very high savings rate (>15%) going into its crisis in the 90s. With real growth so close to zero the Japanese government could issue bonds at extremely low rates for a LONG period of time. That will help their overall debt service cost as they could issue long dated bonds near zero as well as building in the expectation that government returns should/would continue to be low.

2. Its very likely that Japan has some strong incentives for holding G debt- 95% of bonds are held by the Japanese (mostly corporations) which usually occurs when they get massive tax breaks, or other investments are penalized, or both.

3. I believe there are strange rules where the government postal system is used as savings accounts for the majority- and these accounts are pretty much flipped into Gov bonds.

Shouldn't some credit be given for Japan's exports and trade surplus? If countries are like people, Japan is like an excellent brain surgeon with very poor personal finance skills: he may get himself underwater, but he'll always generate a healthy income. Japan does have to import pretty much everything, but its ability to add value to basic inputs is arguably the best in the world.

Greece, OTOH, feels more like the ne'er-do-well brother in law who gets good jobs but has a hard time holding on to them, and has a few ex-wives he's behind on alimony payments with....

My gut feeling is pretty much what jaap wrote. The fact that most of the debt is internal has to help.

In addition, Japan is an exporter, which will support future payments on debt while importing countries have a more difficult turn around ahead. It is kind of like loaning to someone with a good job or loaning to someone without a job.

I would also like to throw in another question. Who are the creditors? I had always envisioned a balance of debtor and creditor countries but, the more I hear about what is going on, it seems like everyone is in debt to one degree or another. Countries that I assumed were holding lots of debt, like China, South Korea and the Middle Eastern countries do hold some of the debt but also appear to be doing a lot of borrowing. Somebody has to be loaning the money and, as a non-economist, I am having trouble with this picture. Where is the money coming from?

One thing to understand about financing sovereign debt is that it is as much a matter of political perceptions as it is about economic fundamentals. If investors, whether, foreign or local, have faith in the leadership and political institutions of a nation and/or the competence of its central bank to enact fiscal reforms, then they will continue to lend to it. This is what Japan and to some extent the US enjoys and Greece doesn't.

Mike Ruelle gets close to something I have been toying with in regards to Japan- that the lending to the government by its citizens will, in the end, turn out to have been nothing more than a tax regime all along. The Japanese, in their consumption profile, seem to have understood this. How many Japanese, today, use income from government bonds to live without working? I am guessing there are few, though an increasing number are using the principle accumulated over time. How does this contrast with other sovereign nations? Is the situation likely to change in Japan with the deteriorating demographic profile? I think so. Japan will face the need to enact actual taxes to replace the borrowing of the past, or replace the domestic-financed borrowing with foreign borrowing, at which point the rollover problem exposes itself.

As far as shorting Japanese bonds is concerned, I am sorry Arnold but I am not aware of a way for retail investors to take options on foreign debt. I would however recommend taking put options on cross pairs Foreign exchange (to avoid dollar issues). i.e. Swiss France-Yen, Norwegian Kronor-yen, or even the pound if you are feeling risky. This way you can also hedge any FX exposure that you may have with buying a put option on a japan ETF.

I'm curious where the idea that 100% of GDP is a magic trip point for trouble came from? As Arnold's favorite economist, Paul Krugman, pointed out, the US blew past 100% debt-GDP in WWII without any clear panic or trouble. Other countrines have gotten into trouble with less than 100% and Japan is due to blow past 200%.

Government's are not the same as individuals but let's keep in mind that having a personal debt ratio several times yearly income isn't all that unusual. A person who puts 20% down on a house and takes out a mortgage is considered rather frugal and conservative these days. Yet few such people make enough in a year to cover their entire mortgage balance!

Of course the objection might be that the individual has an underlying asset of the house. But gov't has a hidden underlying asset which is the right to tax. From an asset point of view this is perhaps the ultimate in diversification. The gov't is kind of like a preferred shareholder in every enterprise in the economy in the sense that it has a right to collect revenue from its success.

If you could have some Wall Street quant package that into some type of security and auction it off in a proper market I suspect its value would be not 100% but multiple times the yearly income of the underlying asset.

To me this implies Krugman's hypothesis is more plausible. It's not so much the ratio to GDP but the markets opinion on the political class. If the political class is perceived as responsible enough to undertake even a half-baked attempt at long term responsibility then there will be no fiscal implosion. If the political class is perceived as irresponsible the panic will strike.

Or let's put it even more simply. A P/E ratio of 14 is not so bad historically. That basically means, though, to buy the entire company at the current price you'd need 14 times the company's yearly income.

Or to put it another way, if you brought 100% of the shares you'd have a right to take 100% of its income. Assuming your interest rate was 0 it would take 14 years of income to earn back what you paid out. (Of course in real life if you started buying lots of shares the price would rise and so would the P/E ratio)

In a sense, though, the gov't is like a shareholder in that it has a right to tax. You as an individual don't get the right to tax a company's earnings unless you first get ownership its shares, take over its board and declare that 100% of profits will be paid out as dividends.

Of course if you did buy all the shares of a company you probably wouldn't take all of its earnings. Leaving nothing to reinvest will almost certainly cause the company to deteriorate. Still, though, the market seems to imply that its perfectly healthy to have a debt ratio much more than 100% of yearly income....

Which implies to me that there's no theoretical reason why 100%, 200% or even a tad more should automatically be a tripwire to fiscal trouble.

Based on what I've read here (thanks to all of you for interesting comments!) I have come up with the following, doubtless badly oversimplified, model for the Japanese economy:

The Japanese save a comparatively large fraction of their income. That savings ought to be going into investment, leading to strong economic growth. However, in reality it is being lent to their government, which spends it inefficiently as governments are wont to (it can be regarded as malinvestment). Therefore the government debt has grown very large, and the economy is sluggish.

Since the Japanese government has no way to repay its debt to the Japanese lenders other than taxing those same lenders, in effect the real savings rate is much lower than the nominal one. Another way to look at this is that savings that feeds consumption (through government in this case) rather than investment is not really savings at all.

The fact that this is more or less a closed system might reduce the danger of collapse due to a rise in the interest rate making the debt burden unbearable. After all, the Japanese government can presumably exert some control over the interest rate within its borders.

No it doesn't sound right. If Japan is 'malinvesting' then the marginal return on private capital investments in Japan should be pretty high. After all a lot of worthwhile private projects haven't happened because the gov't has borrowed the money to build high speed trains and whatnot. So sounds like a great thing, forget about trying to short Japanese bonds, try to get in on some type of private investment opportunities in Japan!

But the crowd out theory works on the idea that gov't borrowing drives up the interest rate. The really great private projects get funding (after all their return is very high), its the marginal private projects that die since they are the ones that go or don't go based on interest rates.

"Government's are not the same as individuals but let's keep in mind that having a personal debt ratio several times yearly income isn't all that unusual. A person who puts 20% down on a house and takes out a mortgage is considered rather frugal and conservative these days. Yet few such people make enough in a year to cover their entire mortgage balance!"

A mortgage is debt secured by an asset. Putting 20% down on a house generally means that your debts can be covered by liquidating that asset- this has nothing in common with unsecured and unbacked debt. Furthermore when an individual realizes he can no longer service his debt he can cut spending or get a 2nd job to ease the pain. On an economy wide basis the size of tax increases or spending cuts can cause shocks which diminish tax returns/GDP and mitigate the effect of these policies. Additionally a house is generally a one time purchase- buying a house may immediately shove your debt/income ratio up but it will then be expected to decline as you won't be buying a house every year, this is not analogous to government debt. The two are simply not comparable.

"I'm curious where the idea that 100% of GDP is a magic trip point for trouble came from? As Arnold's favorite economist, Paul Krugman, pointed out, the US blew past 100% debt-GDP in WWII without any clear panic or trouble. Other countrines have gotten into trouble with less than 100% and Japan is due to blow past 200%."

As has been pointed out by many economists- the 100% debt to GDP ratio (70% is actually one of the more important thresholds) is important because it signals that default is in the near future unless measures are taken to avoid it. The 70% ratio is important because this is roughly the area where most countries borrowing costs exceed growth and it becomes impossible to reduce the debt without spending cuts or revenue increases. The countries that have gone over these thresholds and not defaulted generally have massive spending cuts in short order (ie the US in WW2) or have not defaulted YET but are in pretty crappy positions (ie Japan now).

True a mortgage is secured by an asset but traditionally liquidating the asset to pay off the mortgage is not considered the norm. The norm is considered paying off the mortgage over 30 years. Yes people often have moved from one house to another, selling one and paying off the first mortgage to take another mortgage. But this isn't a good thing for the mortgage industry but an added complication. They are much happier with the person who puts 20% down and spends the next 30 years dutifully paying it off.

Anyway, the point is a single person servicing a debt several times their annual income is not considered all that radical and when you think about an individual person has risks that a whole economy doesn't. An individual person ages, may become mentally unstable, may become disabled or may become unemployable. Nonetheless, for nearly a century people dutifully putting 20% down and taking on debt multiple times their income has caused little issues.

Now the other thing I think you missed is that the gov't does have an asset, it has the legal right to tax. If, in addition to your job, you had a 20% ownership stake in, say, the bar down the street the bank would consider you an even better risk. Well the gov't not only gets 20% of the bar, the drinkers, the delievery man and so on. On top of that, the gov't has the right to say, take 22% if it wants too. You can't get 22% of that bar unless you buy that 2% from someone else first.

So gov't does have an asset, the right to tax the underlying economy. The individual has an asset, their expected future earnings as well as any individual assets they might have. Put the two together and I think its tricky to make the argument that the individual is the better risk.

Additionally a house is generally a one time purchase- buying a house may immediately shove your debt/income ratio up but it will then be expected to decline as you won't be buying a house every year, this is not analogous to government debt. The two are simply not comparable.

Yea I suppose but I'm not seeing how that is sufficient to carry the difference. The house takes a long time to pay down, you don't even make a serious dent in it until 20 years into the mortgage. In the meantime, your main asset, your ability to work and earn income for about 40-50 years has been seriously depleted. In contrast, for the gov't the economy continues to grow with old workers replaced by new workers.

The 70% ratio is important because this is roughly the area where most countries borrowing costs exceed growth and it becomes impossible to reduce the debt without spending cuts or revenue increases. The countries that have gone over these thresholds and not defaulted generally have massive spending cuts in short order (ie the US in WW2) or have not defaulted YET but are in pretty crappy positions (ie Japan now).

But unlike an individual, reducing the debt is not required. A gov't can stablize its debt as a % of GDP and still keep running a deficit. An individual cannot play this game since their ability to earn income is a wasting asset. The 55 year old man is less likely to finish off the 30 year mortgage than the 30 year old.

Recall Krugman's position is not that there's a magic percentage but a magic perception. The perception that the political class will not or cannot act responsibly. If that's the case default can strike at less than 100%, even less than 70% since borrowing costs can suddenly skyrocket (esp. if the country has to borrow in a currency other than its own). If that's not the case I suspect it remains quite possible for a developed economy to maintain debt levels in excess of several hundred percent of GDP.

The countries that have gone over these thresholds and not defaulted generally have massive spending cuts in short order (ie the US in WW2) or have not defaulted YET but are in pretty crappy positions (ie Japan now).

I'm not clear how Japan being in a crappy position is supposed to make investors feel more secure that default is unlikely? Instead I suspect the market feels Japan's political system, as messy as it is, is responsible enough to maintain its servicing of the debt, keep massive expansions of it to acceptable causes (demographic bumps, recessions etc.) and address long run issues at some point.

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